More Banks Turn to Private Equity Funds

Following a trend among big financial institutions, Bank of America plans to raise as much as $1 billion from wealthy clients

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From Standard & Poor's Equity Research
Earlier this month, Bank of America, the No. 2 U.S. bank, joined a formerly exclusive club: the major financial institutions with private-equity funds. Bank of America hopes to raise as much as $1 billion for a private-equity fund, seeking people willing to invest at least $500,000, according to an Aug. 9 filing with the Securities & Exchange Commission.

Some Bank of America (BAC; ranked 5 STARS, strong buy) rivals and investment banks have plans to fund—or have already set up—their private-equity coffers. They include: Citigroup (C; ranked 5 STARS) , Credit Suisse (CSR; ranked 4 STARS, buy), Goldman Sachs (GS; ranked 5 STARS), and Merrill Lynch (MER; ranked 5 STARS).

Firms continue to count on institutional and wealthy clients' interest in hedge funds, venture capital, and leveraged-buyout funds as the returns on investments they would otherwise realize from the stock market have paled. Over the last two decades, U.S. buyout funds produced average annual returns of more than 13%, vs. 11% for the Standard & Poor's 500 index, according to the National Venture Capital Assn.

STILL SPROUTING. Funding and marketing a private-equity fund has become nearly commonplace for white-shoe firms and big banks as billions of dollars from institutional investors continue to chase fewer high-yield public investments. Recently, clients with millions of dollars and high-risk tolerance profiles have witnessed the robust returns of billion-dollar funds through generally unregulated private deals—so much so that most of the financial institutions now favored by S&P's have a strategy that includes private-equity funds.

S&P equity analyst Mark Hebeka views the trend in private-equity growth positively for the banks he follows, citing the funds' ability to offer existing clients a new investment vehicle while potentially attracting new customers. He expects funds will continue to originate at a rapid pace for the next several years until competition increases to a point that returns begin to diminish.

The burgeoning business appears to be expanding further. Private-equity funds may raise up to $300 billion this year, industry-research firm Private Equity Intelligence says. That would be about 50% higher than the amount raised last year, but the number includes banks as well as traditional buyout firms, such as Bain Capital, Blackstone, Kohlberg Kravis Roberts, Thomas H. Lee Partners, and TA Associates (see BusinessWeek, 2/27/06, "Going Private").

DIVERSITY PLAY. Meanwhile, some banks are distancing themselves from the business, in part to avoid conflicts of interest with hedge-fund clients, Hebeka explains. J.P. Morgan Partners, a private-equity unit of JP Morgan Chase (JPM; ranked 4 STARS), will become independent when it completes the investment in its current $6.5 billion Global Fund, which is expected to happen this year. Meanwhile, Morgan Stanley (MS; ranked 3 STARS, hold) established an independent private-equity firm, called Metalmark Capital, which will manage the more than $3 billion-strong Morgan Stanley Capital Partners funds through a long-term sub-advisory role.

"In general terms, we believe it can serve as a good diversifier for affluent clients as well as offer the potential for higher returns, albeit with increased risk," Hebeka says. The risk, he says, is that these funds often buy out distressed companies.

The latest example of a company going private is HCA (HCA; ranked 3 STARS, hold). Last month, affiliates of Merrill's private-equity arm and two buyout firms agreed to acquire HCA, the largest U.S. for-profit hospital chain, in a deal valued at $33 billion, including $11.7 billion in debt. The deal was well received by the capital markets.

In addition to increasing the banks' client base, private-equity funds are also a positive development for investors since they can capture some appreciation along with the significant fees that are generated by the deals, according to Hebeka. These fees can either complement other revenue-generating businesses for high-net-worth clients or offset losses in other businesses. Thanks in great part to a healthy economy and low borrowing costs, private-equity funds may continue to raise record sums.

Sender is a reporter for Standard & Poor's Global Editorial Operations

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report.
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